Question 2 1 pts Bob Inc. currently has total capital equal to $10 million, has

Question

Question 2 1 pts Bob Inc. currently has total capital equal to $10 million, has zero debt, is in the 30% federal- plus-state tax bracket, has net income of $1 million, and distributes 30% of its earnings as dividends. Net income is expected to grow at a constant rate of 10% per year, 500,000 shares of stock are outstanding and the current cost of equity is 12%. The current stock price is $33. The company is considering a recapitalization where it will issue $3.3 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its cost of debt will be 10% and its cost of equity will rise to 14%. Assuming that the company maintains the same payout ratio and can buy back the shares are $33 each, what will be its stock price after the recapitalization? $25.32 O $15.86 O $42.75 O $62.56

Explanation / Answer

EBIT = Net income / (1 - tax rate) = 1/(1-30%) = 1.43 million

After recapitalization

Net Income = (EBIT - Interest)*(1 - tax rate)

Net Income = (1.43 - 10%*3.3)*(1-30%) = 0.77 million

Outstanding shares = 500000 - (3.3/33)*10^6 = 400000

Dividend = 30%*(0.77*10^6 / 400000) = 0.5768

Price = Dividend *(1+g) / (r - g)

Stock price = 0.5768*(1+10%) / (14%-10%) = 15.86 (Option B)

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